Chapter 01 – How to manage debt

Debt is a fact of life for most clients. It may come from starting a business, buying into a business, buying a home or acquiring investments. It requires careful management and control so it does not cause financial loss and pain, rather than wealth creation.

Unless you are born wealthy, there is normally no choice but to borrow to acquire assets of any significant value. It is hard to save up $600,000 to buy a home. By the time you do, you will probably be looking for a retirement home anyway.

A controlled amount of debt, used intelligently, can have a great influence on the quality of your life and on your net wealth position. It allows you to acquire assets otherwise outside of your reach and to benefit as the value of the assets rises and as the debt is gradually repaid.

Consumer debt

Consumer debt is debt incurred on consumer products and services. Consumer debt is usually very expensive – some credit card debts charge up to 20% per annum – and is not tax deductible because it does not relate to assessable income. Credit cards are typically used to buy consumable goods and services, and these fall in value over time. People using credit cards to buy such goods are usually reducing their net wealth.

Some consumable goods and services are unavoidable. Food, shelter, clothing, and health are all things people need. They are often referred to as non-discretionary consumable items, as the buyer does not really have the discretion to decide whether to buy them.

When the purchase is made on a credit card, and the buyer pays interest, then the price of the purchase becomes even higher. This increases the negative effect on net wealth.

Not all credit card purchases attract interest. Most cards allow an interest-free period. If the user of the card pays the credit card bill in full before interest charges are applied, then they do not pay interest. However, only 30% of credit cards are repaid within the interest-free periods, meaning 70% of credit card users pay interest.

We once met a client with a credit card debt of more than $250,000! The interest bill was about $50,000 a year, and the client had to earn nearly an extra $100,000 a year just to pay the interest: 20% non-deductible is the equivalent of nearly 38% deductible. That’s extremely expensive money and it’s impossible to get ahead. Particularly if it means you have to work seven days a week every week just to make ends meet.

Happily most clients know consumer debt is expensive and avoid it wherever possible. Encounters like this are very rare. Our client ended up consolidating the loan on to his home loan, and effectively reducing the interest rate to a much more manageable 5% per annum.

Home loan debt

Home loan debt is debt incurred on buying, maintaining or improving a home. Home loan debt is usually not that expensive, since the loan will be secured by mortgage over the home, and this means there is little risk for the lender. Rates are currently about 5%.

Home loan debt is easily the most common form of personal borrowing in Australia as it accounts for more than two-thirds of total borrowing. The interest rate on home loans is usually lower than the borrower could achieve for other types of debt because the lender typically takes a mortgage on the home. A mortgage is a form of security arrangement that gives the mortgage holder (the lender) the right to order that the asset be sold in the event that the terms of the loan agreement are not met. Because of this right, the risk to the lender is less than it would be in other cases. Consequently, the lender is happy to accept a lower rate of return from the borrower. 

Sometimes, an individual assists another individual to undertake a home loan. For example, parents may allow their children to use the parental home as security for a home loan. This is known as guaranteeing the loan. This type of borrowing is included within the range of owner-occupied borrowing.

Home loan debt is not tax deductible: it is not incurred for the purpose of producing assessable income and it is inherently private and domestic in nature. This means a client has to earn nearly $2.00 for every $1.00 of home loan interest, and 5% non-deductible is the equivalent of nearly 9.5% deductible if the client is in the highest marginal tax bracket. That’s expensive money. Although not impossible, it’s hard to get ahead with that sort of a millstone around your neck.

Clients should pay off home loans as fast as possible. Paying off a 5% home loan is the same as earning up to 9.5% capital guaranteed, adjusted for tax. That’s the best investment a client will ever make (except for owning a business).

Interest offset accounts

Interest offset accounts are recommended for all clients with home loans. Don’t pay off the home loan, and don’t put the money on deposit either: pay into the interest offset account instead. There are two advantages:

  1. the client does not get taxed on interest income, and instead pays less non-deductible interest (equivalent to 9.5% per annum); and
  2. the client can withdraw their equity from the offset account when up-grading the home, and retain the old home as a geared residential property investment. (The client can also easily withdraw money for any other purpose as well). 

Strategies for Paying off the Home Loan Faster – Intergenerational Financial Planning

In terms of paying off the expensive home loan, faster, there are some particular strategies that can be used when a vertically extended family is treated as if it is, in fact, one large client. This kind of vertical integration across the generations is known as intergenerational financial planning

The principle is that the entire family thinks about who within the family is paying off expensive private debt. The family then thinks about the best way to minimise this debt. Often, things like super can be utilised – and not necessarily the super account for the person in whose name the debt is held. 

It always pays to remember that, ultimately, private housing must be bought using after-tax dollars. The deposit used to purchase a private residence, for example, must be saved after tax is paid on the purchaser’s income. The principal and interest payments on the loan must also be paid out of after-tax income. Ultimately, the whole property is paid for after-tax.

As a result, it becomes clear that, where the tax payable on income is lower, it will require less pre-tax income to buy the same amount of house. The following table shows how much pre-tax income is required to buy a $500,000 property for various marginal tax rates.

Tax Rate

Pre-Tax Amount Required

Tax Paid

Amount Remaining

0%

$500,000

0

$500,000

15%

$588,235

$88,235

$500,000

19%

$617,284

$117,284

$500,000

32.5%

$740,741

$240,741

$500,000

37%

$793,651

$293,651

$500,000

45%

$909,091

$409,091

$500,000

The second column shows the pre-tax cost of a $500,000 property. The 15% tax rate is that rate payable on deductible super contributions into a super fund. The point of the table is this: if families make deductible super contributions into someone’s super fund, and then withdraw these contributions tax-free when that someone person reaches the age of 60 and use it to pay for housing, the family needs only to earn $588,000 pre-tax to buy the $500,000 property. If the relevant part of the family instead pays tax on income at 45%, and then uses what’s left to pay off the loan directly, the $500,000 property costs over $900,000.

Judicious use of super can reduce the cost of a property by more than a third.

Because of this, wherever a property needs to be purchased somewhere within a family structure, it pays to think about whether the ‘super effect’ can be utilised.

Investment debt

Investment debt is different to consumer debt. Properly managed investment debt typically improves the client’s overall economic returns and helps build long term wealth. Economic theory predicts in the long run interest rates will be less than the average returns on properties and shares. This is because, if it is not the case in the short run, borrowers will stop borrowing. This reduced demand will lower interest rates. Eventually interest rates will fall below the average returns on properties and shares, plus a premium for risk. At this point, borrowers will recommence borrowing.

Borrowers will only borrow if they expect average returns on properties and shares to be greater than the interest rate. This means most clients who borrowed to buy representative properties and shares over the last two decades increased their wealth by doing so. This is because the assets earned more than 9% per annum, but only cost about 7% per annum. This is what we have seen with our clients over this time too. For example, the client who borrowed big to buy a Brighton investment property in 2000 for $550,000, who geared it up again in 2006 to extend it for another $500,000, and who in 2014 owns a debt free $2,000,000 CGT-advantaged asset producing about $120,000 in rent a year.

Since interest rates are so crucial to the overall rate of return, the majority of investment borrowing is secured against an asset or assets held by the investor. Secured loans incur lower interest rates. The assets offered as security may or may not be the same as the assets purchased using the loan. For example, many investors who own their own home borrow against their home to finance other investment assets. The benefit of this is that offering the family home as security typically allows the investor to minimise the interest rate payable.

Secured debt versus unsecured debt

When a person undertakes debt, the debt can be either secured or unsecured. If secured, this means that the borrower has acquired some rights over property belonging to the borrower. These rights typically allow the lender to order that the property be sold and the proceeds of the sale be used to repay the loan. Standard loan agreements only allow the lender to make this order under particular circumstances – typically if the borrower has failed to make a repayment as agreed under that loan agreement. This is known as defaulting.

If a loan is unsecured, this means that the lender does not acquire the rights to order that specific assets be sold and the proceeds used to repay the debt. With an unsecured loan, if the borrower defaults then the lender typically needs to take the borrower to court. The courts can force the borrower to dispose of assets in order to repay debt. However, they can only do so on the assumption that the borrower has sufficient such assets. If the borrower does not, then the court may order that the borrower be declared bankrupt.

Unsecured loans create greater risk for the lender. Thus, the lender typically requires a greater return on the investment they are making to the borrower, to justify the increased risk. The return to the lender is the interest paid by the borrower. Thus, the interest paid by the borrower is a function of the risk of the loan, which is in turn a function of the security offered (or not offered) for the loan. 

Unsecured loans are the highest risk. However, within the range of secured loans, the risk can vary according to the stability or otherwise of the value of the assets being used as security. A residential property, for example, tends to have a more stable price than shares in a public company. Thus the interest rate for a loan secured by residential property is typically lower than that for a loan secured by shares.

Of all the asset types, the prices of residential housing tend to be the most stable. Therefore the interest rates available for loans secured against residential property tend to be the lowest. Interest rates for loans secured against other types of asset then rise according to the relative stability of the value of that asset.

Loan to valuation ratios

Another determinant of the risk of a loan is the loan to valuation ratio (LVR). The ratio expresses the amount borrowed as a percentage of the value of the asset being used as security. For example, where a borrower borrows 80% of the purchase price of the residence and offers the residence as security, the LVR is said to be 80%.

Loans with a lower LVR are said to be lower risk than those with higher LVRs. This is because the potential for the asset with a lower LVR to fall in value so that the lender cannot recover the whole debt should the asset be sold is less than that for assets with higher LVRs. For example, if a residential property has an LVR of 95%, then it only needs to fall in value by 5% for the property to become worth less than the amount of the debt. A property with an LVR of 80% must fall in value by 20% before this happens. The chance of a property falling by 20% is less than the chance of a property falling by 5%. Thus, the higher LVR indicates greater risk for the lender.

The borrower

The likelihood that a borrower will repay a loan also determines the risk, and thus the price, of that loan. For example, a borrower with a very high income who is borrowing a small amount will typically find it easy to repay the debt. Thus the risk is lower than in cases where a person with a low income borrows a large amount. Similarly, over time, individuals develop a personal credit rating. This rating is determined by the success with which previous loans have been repaid. Individuals with a poor track record for repaying loans will typically find that lenders require them to pay higher rates of interest.

A significant number of clients who seek the services of a financial planner have some personal debt. For those who do not or do not have relatively low levels of debt, consideration should be given to whether debt could be used as a part of an investment and wealth-creation strategy. For that reason, substantial attention must be paid to debt in the financial planning process.

The most common reason that people in Australia borrow money is to purchase the home in which they live. This home, which is typically not classed as an investment, should still be examined as part of the financial planning process. For many people, their home is the most significant individual asset they own. It is also of course the place where they live, the place where they spend the most time and subsequently has the biggest impact on their happiness and satisfaction.

The increasing importance of the family home to personal finance is shown in the following graph based on the Reserve Bank of Australia October 2015 household sector data. The orange line shows total personal wealth as a percentage of average household disposable income. The purple line shows that part of total wealth that comprises the family home.

household-wealth-and-liabilities

In addition to the family home, clients of a financial planner typically borrow money in order to invest. In general, investors borrow to buy one of two types of investment assets:  property or securities. These assets can be held either directly in the hands of the investor or indirectly via an asset manager. Personal expenditure includes borrowing for private housing (owner-occupied borrowing) and credit cards. Investment borrowing is where money is borrowed to purchase assets intended to provide a financial return. 

For a broad review of personal debt in Australia, read the Australian Bureau of Statistics analysis of Household debt in 2014.

The Dover Group